The fall of communism and attempted transition from plan to market in Central and Eastern Europe and across the former Soviet Union presented Austrian theorists with a challenge: while much work had been made of the problems of socialist calculation, how could an Austrian worldview encompass the change from a centralized state that ruined economies to a more laissez-faire world? And what would the societal impact be?

Nearly 20 years after the Berlin Wall fell, mainstream economists continue to argue about transition economics, with some placing it in a subset of "development economics" (the same fad-driven subdiscipline that was responsible for encouraging socialism in the 1950s and '60s, and then shifted abruptly to encouraging different types of socialism in the 1980s). Still others have attempted to put transition economics in the same category as "growth economics," which sees economies driven by labor and capital and their starting point on the growth curve, with little heed to institutions. As this argument has raged, fairly little Austrian analysis has emerged regarding transitional economies and, more importantly, how transitions should look (a paper in 2002 asked if there even was an Austrian approach).[1]

Fortunately, 20 years of experience gives us an excellent vantage point to view the process of transition from communism to capitalism, and. more importantly, compare policies to see what has worked and what hasn't. Can we explain differences in performance since these societies shed their communist trappings and moved towards capitalism? Is there an analytical framework that is better than conventional models to explain transition outcomes?

Divergence

While little Austrian analysis has been done, this does not mean that transition economies have not succeeded or failed according to Austrian tenets. The first thing that strikes any observer of transition economies is their wide divergence since transition was attempted. Some countries have grown very rapidly and thoroughly shed central planning: Estonia, Slovenia, and possibly some Central European countries (such as Slovakia) have catapulted to the head of the line with excellent GDP growth, lower unemployment, and development of healthy private sectors. On the other hand, many countries, including most of the former Soviet states (excluding the Baltics) have continued to stagnate across a range of indicators. What is the source for this divergence?

The real reason is that, in many of these countries, "transition" has been a phrase rather than a process, a slogan rather than a reflection of what is happening on the ground. Many of the former Soviet countries are headed by Soviet-era leaders who may have loosened the reins on the economy but have tightened them politically, leading to meddlesome and corrupt bureaucracies that stifle job growth. Countries such as Uzbekistan, Armenia, and Azerbaijan are run by corrupt cliques and show little tolerance for opposition, while at the same time doling out economic favors via the state. Some of these countries continue to show moderate GDP growth (with countries that are autocratic but in possession of oil, such as Turkmenistan, Azerbaijan, and Russia showing impressive GDP growth), but underneath this "catch up" (growth from a low base), a broad range of indicators show that the progress is only illusory. Unemployment is frustratingly high, up to 30% unofficially in some countries, and jobs are not being created on a broad scale - entrepreneurship cannot flourish in a stifling government atmosphere.

Not surprisingly, the best performers are those that have gone the furthest in demolishing the power of the state (see Figure 1). There is a clear correlation between average GDP growth and a country's Freedom House ratings (averaged) over the period of transition.[2] While some outliers exist, they tend to be either the oil-rich states mentioned above, or they are late transition economies, like Albania (which has swung far the other way in terms of liberalization, but is still hampered by its early lack of reform). On the whole, removing the power of the state from economics has improved the lives of former communist citizens.

Figure 1 - Average Growth, 1991-2007 versus Freedom House Average over the Same Time

Source: EBRD Transition Indicators, Freedom House.

A prime example of how one country shifted from corruption to capitalism has been shown by the tiny Republic of Georgia: headed for nine years by the last foreign minister of the Soviet Union, Eduard Shevardnadze, the country was renowned for being a cesspool of corruption and it plodded away with slow growth and a low standard of living. The "Rose Revolution" of 2003 swept out Shevardnadze and his cronies, however, and instituted an excellent set of market-friendly initiatives (such as a 12% flat tax). The result has been stellar growth for Georgia, increased investment, and a freer society. Problems remain, but the plumbing of communism has finally been ripped out: it's up to the private sector to rebuild the house.

This trend in better economic performance for freer transition countries has not occurred at just the aggregate level, as transition economies have differentiated themselves at the sectoral level as well. In fact, there's a gulf between sectors that have been given less state attention or have been privatized (or are in countries that have reduced the power of the state) versus those that are still protected or under state control. Uzbekistan, for example, remains one of the former Soviet countries that have shifted the least from its legacy of central planning, and it retains a complex "industrial policy" directed by the same people who ran the economy into the ground under formal communism. The results in the new "market economy" of Uzbekistan are exactly the same as under the "people's democracy," however. As Table 1 shows, the industries that the government promoted most heavily in its first industrial policy from 1996 quickly became the industries that suffered the most.

In contrast, firms in countries that have left the market to the market have surged ahead and, in some instances, are now world leaders. Skype, for example, an indispensable tool for anyone living outside of the US or conducting business globally, was started in Estonia, while Škoda, the Czech car manufacturer once the butt of many jokes, has been acquired by Volkswagen and is now making high-quality-yet-affordable cars for a broad range of markets.

This anecdotal evidence has been backed up by empirical research: a broad examination of enterprises in Central and Eastern Europe and the Commonwealth of Independent States (CIS) countries done by World Bank researchers found that privatizing a firm not only led to the firm's restructuring, it also added "several percentage points to [the] enterprise['s] growth rate."[3]

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Even more breathtaking (but readily apparent to an Austrian economist), enterprises faced with competition outperformed state monopolies by 20-30 percent, depending on the country.[4] Governments that stepped out of the way and allowed for foreign investors to chase returns fared the best, with privatized or Greenfield investment in the transition economies from foreign owners "always the most efficient … since 1993."[5] Indeed, foreign-owned firms played a vital role in transition, both reducing monopoly rents in the brief phase of asymmetric information, while also leading by example for domestic firms (which had caught up in efficiency for the most part by 2000).[6]

What Needs to Be Done?

There are many striking examples of how transition can be effective, and many depressing ones on how transition has, in fact, stalled in the face of state intervention. While more research is needed in the Austrian vein to examine the specific effects of calculation in a transitioning state, how institutions develop in states of uncertainty, and how private sectors can lead transition rather than be passive reactants, it is clear that the outcomes Austrians expect in all economies indeed hold true in transition economies as well. Given the results of the past 20 years, it is difficult for policymakers to argue that socialism can work here while it didn't work there.